Wednesday, September 27, 2017

Reynolds, From Here to Security

Robert L. Reynolds, president and CEO of Great-West Financial and Putnam Investments, was a pioneer in the 401(k) business for Fidelity Investments in the 1980s and 1990s. In From Here to Security: How Workplace Savings Can Keep America’s Promise (McGraw-Hill, 2018) he advocates improving and extending workplace savings plans.

First, however, it is imperative to make Social Security—“the country’s largest, most successful, and most popular government program”—solvent over the long term. “As multiple bipartisan commissions have shown in recent years, the compromises needed to restore Social Society to fiscal health are blindingly obvious, namely a balanced combination of revenue increases and benefit cuts.” The problem is that Social Security has long been viewed as the “third rail” of American politics—“Touch it and you die!” Moreover, compromise is not exactly the hallmark of Congress these days.

To supplement Social Security, working Americans traditionally relied on defined benefit pensions. But today pensions are flat-lining. Defined contribution plans are taking their place, extending coverage to more workers and workplaces. Roughly half of American workers have access to 401(k)-type plans. The problem is that, although they serve middle- and upper-income workers well, they don’t reach low-income, part-time, or contingent workers—or those in small firms that have no payroll savings plans at all. This is especially troubling in a gig economy.

Moreover, it is not enough to extend 401(k)-type plans to more workers. Reynolds suggests that the holy grail of the next generation of workplace savings is “to convert accumulated assets into guaranteed lifetime income” so that people won’t run out of money before they run out of time. Annuities are one obvious solution to this problem, although annuities often get a bad rap.

Reynold’s book, which describes where we’ve been and where, in his opinion, we should be going to achieve retirement security for the largest number of American workers, raises policy issues that should definitely get more attention in Washington.

Sunday, September 24, 2017

Kula et al. Beyond Smart Beta

More than 4,400 ETFs are currently available globally, and more than one million indices are calculated daily—“a dizzying range of asset classes, strategies and exposures.” In Beyond Smart Beta: Index Investment Strategies for Active Portfolio Management (Wiley, 2017) authors Gökhan Kula, Martin Raab, and Sebastian Stahn explore exchange-traded products and the evolution of indexing to “unchain innovation—the future of active investing in passive products.”

After a lengthy account of the characteristics of exchange-traded products, the authors turn to the evolution of indexing. The first generation of indexing ties classic benchmark indices to “the market”—the Dow Jones Industrial Average, to cite the most classic. The authors provide 24 mostly full-page tables highlighting the main features of major benchmarks—equity, sector, fixed-income, and commodities.

Smart beta indices represent the second generation. They are “designed to provide exposure to specific factors, market segments or systematic strategies.” Typical factors are value, size, momentum, low volatility, quality, and dividend yield. The authors analyze each of these factors, pointing out their advantages and disadvantages.

In the third generation of indexing, optimized indexing is combined with risk-based dynamic asset allocation. This generation of indexing aims “to control for and to mitigate costly behavioral biases.” One example is target volatility indexing. “Investors in equity-based ETFs are always better off in the long run investing in the corresponding target volatility ETF instead of the pure equity ETF.” Another example is the best-of-assets strategy, which switches allocation levels between equities and fixed-income depending on specific market signals.

One trend that has legs is customized indexing, where investors can construct a bespoke index solution that may exhibit a better risk-return profile for their specific needs. MSCI is currently calculating more than 7,000 customized indexes globally for over 700 clients, around 70% of which can be launched within 48 hours.

Academics keep churning out papers, firms keep churning out new ETFs. There’s no end in sight.

Wednesday, September 20, 2017

Zeisberger et al., Mastering Private Equity

Claudia Zeisberger, a professor at INSEAD, and two INSEAD alumni, Michael Prahl and Bowen Whtie, joined forces to write Mastering Private Equity: Transformation via Venture Capital, Minority Investments & Buyouts and its companion case study volume Private Equity in Action—Case Studies from Developed and Emerging Markets (Wiley, 2017). Industry professionals added their thoughts to each chapter of Mastering Private Equity.

The core book, written for both graduate students and professionals, is structured like a textbook (including lots of color). It is divided into five sections: private equity overview, doing deals in PE, managing PE investments, fund management and the GP-LP relationship, and the evolution of PE.

Mastering Private Equity is a model of clarity. For instance, in a table the authors summarize the advantages and disadvantages of various exit options. The advantages of a sale to a strategic buyer are: full exit, often pay a premium (synergies), pay in cash. The disadvantages are: less sophisticated buyers prolonging process, strategics require a majority stake. The advantages of a sale to a PE fund are: ample dry powder in market, can ‘warehouse’ company until eventual IPO. The disadvantages are: sophisticated and demanding buyers, minority stake may reduce pool of potential investors. As for an IPO, the advantages are: potential for high returns, access to future liquidity, often preferred by management, high profile exit. The disadvantages are: lock-up, risks of going to market, uncertainty of returns, strain on management time. The last alternative is a dividend recapitalization. Here the advantages are: returns cash to limited partners, no new shareholders, does not dilute equity stake. The disadvantages are: partial exit, value of investment unknown, not a high profile exit.

All of the cases covered in Private Equity in Action are taught in INSEAD’s various business programs. They span the globe, from an Indian vineyard and rice farming in Tanzania to creating a private equity fund in Georgia.

Anyone who wants to better understand private equity, especially PE with a global reach, would do well to read these books.

Sunday, September 17, 2017

Henriques, A First-Class Catastrophe

Black Monday (October 19, 1987), when the Dow Jones Industrial Average fell over 22%, was not a black swan event. Although it occurred in the context of heightened geopolitical risk, with Iran hitting two American-owned ships with Silkworm missiles and the United States retaliating by shelling an Iranian oil platform in the Persian Gulf, the potential for a huge market sell-off had been telegraphed day after day in 1987.

Diana B. Henriques, an award-winning financial journalist writing for The New York Times, is the author of The Wizard of Lies (the best-selling book about Bernie Madoff, subsequently made into an HBO movie), Fidelity’s World, The Machinery of Greed, and The White Sharks of Wall Street. In A First-Class Catastrophe: The Road to Black Monday, the Worst Day in Wall Street History (Henry Holt, 2017) she once again lives up to her reputation for careful, exhaustive research and engaging prose.

People (I among them) have often claimed that the financial market is a complex adaptive system. Henriques convincingly shows that, in the run-up to Black Monday, it was complex but not reliably adaptive and certainly not a system. Moreover, she claims, “we are still living in the world revealed to us on Black Monday.” In fact, the factors that led to the 1987 crisis “have become even more deeply embedded in Wall Street’s genetic code.”

Henriques explores multiple areas in which the financial market (and here I include equities, bonds, and derivatives) exhibited the potential for cracks in the 1970s and 1980s, starting with the fractured regulatory agencies. Also contributing to the crisis was the introduction of indexing, initially for pension funds, would give rise to herding; these huge funds were “all likely to shift their assets in the same direction at the same time.” Portfolio insurance, often incorrectly cited as the cause of Black Monday, relied on index arbitrageurs (and there had to be enough of them) to zig when it zagged. Computerization sped up trading and the back office processing of orders but brought with it the inevitable glitches.

Populating these potentially problematic areas were people who were protective of their turf, powerful, and creative—regulators and heads of exchanges, agents for financial behemoths, and innovators. As a result of the extensive interviews the author did with the primary players, we get a sense of how they understood their roles in this calamity.

A First-Class Catastrophe is a first-class book. Perhaps through it we will learn some lessons that were ignored in the wake of Black Monday.

Wednesday, September 13, 2017

Page, The Diversity Bonus

Scott E. Page is one of my favorite writers. A professor of complex systems, political science, and economics at the University of Michigan, he is the author of The Difference, Complex Adaptive Systems, and Diversity and Complexity. He also gave a wonderful on-line course on model thinking, still available on Coursera.

The Diversity Bonus: How Great Teams Pay Off in the Knowledge Economy (Princeton University Press, 2017) continues his thinking on the complicated, often contentious subject of diversity. The core logic for how diversity produces bonuses relies on linking cognitive diversity (differences in information, knowledge, representations, mental models, and heuristics) to better outcomes on tasks such as problem solving, predicting, and designing. Cognitive diversity is to be distinguished from identity diversity (differences in race, gender, age, physical capabilities, and sexual orientation), although identity diversity can often contribute significantly to cognitive diversity.

Some people try to view diversity as analogous to a diversified investment portfolio, but they miss the point. “The portfolio performs like the average. The problem-solving team performs like the best. Actually, the team does even better if team members can share ideas.”

Page is careful not to overpromise on the benefits of diversity. Although in some cases cognitive and identity diversity produce bonuses, “in others (see the US Congress) they contribute to conflict.” Wall Street, however, is a place where both cognitive and identity diversity pay off. “Team-run funds outperform individuals and gender-mixed teams outperform all-male teams.”

Page’s book offers a compellingly pragmatic justification for both cognitive and identity diversity. Unlike normative arguments for identity diversity and inclusion, which “seek to redress past wrongs or create a more equitable future,” the diversity-bonus logic “shows that cognitively diverse teams perform better on complex tasks.” The widespread view that diversity harms performance (exemplified by Antonin Scalia’s opinion that schools and employers face a choice: they can choose diversity, or they can choose to be “super duper”) overstates the case. True, “replacing a member of a relay team with a slower runner or hiring a data analyst who makes errors at a higher rate based on identity considerations sacrifices quality on the altar of social justice.” But when it comes to complex tasks, having a diverse team is not a sacrifice but is often instead a benefit.

Sunday, September 10, 2017

Kinlaw et al., A Practitioner’s Guide to Asset Allocation

William Kinlaw, Mark P. Kritzman, and David Turkington have written a carefully researched book that reaches sometimes counterintuitive (or at least counter to common wisdom) conclusions. A Practitioner’s Guide to Asset Allocation (Wiley, 2017) is directed at professional investors and advisors, but some of the material might be useful to systematic traders as well. Although the authors rely on quantitative analysis, they do not overwhelm the reader with math and statistics. For those who need a brief refresher course to understand the gist of the text, there is a chapter late in the book explaining basic statistical and theoretical concepts.

Among the misconceptions the book sets out to rectify are:

1. Asset allocation explains more than 90% of investment performance.

2. Investing over long horizons is less risky than investing over short horizons.

3. Factors offer greater potential for diversification than asset classes.

4. Equally weighted portfolios perform better out of sample than optimized portfolios.

The authors explore such questions as whether, to increase expected return, it’s preferable to apply leverage to a less risky portfolio than to concentrate a portfolio in riskier assets, as theory holds. Answer: “what is inarguable theoretically does not always hold empirically when we introduce more plausible assumptions.”

They also address the thorny problem of regime shifts. They investigate three approaches to managing risk (using volatility as a proxy for risk): stability-adjusted optimization, regime-sensitive asset allocation, and tactical asset allocation based on regime indicators. They suggest that the first two approaches “yield static portfolios that most likely will still experience wide swings in their volatility.” Tactical asset allocation is more flexible, and “although this additional flexibility may not always improve performance, we have provided encouraging evidence to suggest that some investors might profit from tactical trading, given the right insights and methods.”

There’s a lot of meat in this book. Investors and advisors who devote time to it, especially those with some quant skills, will come away enriched.

Friday, September 8, 2017

Zomorodi, Bored and Brilliant

Boredom has become a fashionable subject. Henry Alford, in his New York Times (August 10) review of seven books about boredom, suggests that “the ‘boredom boom’ would seem to be a reaction to the short attention spans bred by our computers and smartphones.” Boredom is something we have lost to technology--something, we are told, we should strive to regain. Most authors these days aren’t seeing boredom as “the graveyard of your spirit” but as “a lull before the gorgeous storm.”

Put down your smartphone. The boredom that follows will foster creativity. Or at least that’s the thrust of Manoush Zomorodi’s Bored and Brilliant (St. Martin’s Press, 2017). The author, host of her own weekly radio show and podcast on WNYC, Note to Self, created the Bored and Brilliant Project. It was “a weeklong series of challenges designed to help people detach from their devices and jump-start their creativity.”

If you’re addicted to your gadgets, Zomorodi’s book might help you step back a bit. If, however, you want to understand how having free time can trigger your imagination, you’ll have to turn elsewhere. Similarly, if you want to understand what boredom is in all of its varied manifestations, you’ll need another guide.

Thursday, September 7, 2017

Gardner, The Motley Fool Investment Guide, 3d ed.

The Motley Fool will probably always be most closely associated with the 1990s and the roaring stock market. But their business is still going strong. And so now, for the third edition, David and Tom Gardner have completely updated their classic The Motley Fool Investment Guide: How the Fools Beat Wall Street’s Wise Men and How You Can Too (Simon & Schuster) for a new generation of investors.

For those with the motivation and the proper temperament, the Gardners advocate stock picking over index investing. They are partial to small caps and recommend “’business-focused investing’—that is, seeking out great and amazing growth-opportunity businesses.”

Tom Gardner, in constructing his Everlasting Portfolio, considers five features of companies: culture, strategy, financials, safety, and valuation. David Gardner is more aggressive. He advocates Rule Breaker investing, which is about “seeking growth in dynamic companies that are disrupting and shaping industries, businesses, economies, and even our daily lives.” These companies are the first movers in important and emerging industries, they have visionary leadership and smart backing, they have identifiable competitive advantages, they’re good brands, their stocks have already done pretty well, and stodgy backward-looking observers will declare their shares overvalued.

After the authors take the would-be investor through some basic accounting principles, they introduce advanced topics, such as shorting stocks and options.

To the new investor, the authors say “there’s no rush. Consider starting with an index fund or some blue-chip stocks exclusively in your first year. … When you’re convinced you can outdo index-fund investing, and you’re confident you have the timeline and temperament to stick with it even when things don’t go your way, explore the worlds of Rule Breakers, small-cap stocks, and other corners of the market that might appeal to you. Find your edge, and then over time, push your edge to the edge.”

Wednesday, September 6, 2017

Tillinghast, Big Money Thinks Small

Joel Tillinghast, the sole manager of the Fidelity Low-Priced Stock Fund from its inception in 1989 until 2011, when six co-managers were added, has been an outperformer. A $10,000 investment in his fund when it launched would have been worth almost $300,000 in 2015, versus roughly $74,000 for the Russell 2000 and $104,000 for the S&P 500. So it’s definitely worth listening to what he has to say in Big Money Thinks Small: Biases, Blind Spots, and Smarter Investing (Columbia Business School Publishing, 2017).

Tillinghast’s book is a cornucopia of investing wisdom, some acquired as a result of the inevitable mistakes, which he readily shares.

One bit of wisdom, which is not commonplace, is that Tillinghast focuses on a business’s distinctive character rather than its business strategy or positioning. “Most companies lack a strong character. This does not mean that they will be poor investments—only that they are less apt to be exceptional.” As examples of character, Tillinghast writes that, to him, “Apple seems smart, elegant, and occasionally quirky but otherwise easy to get along with. GEICO is honest, thrifty, and good-natured.”

He lists six things that make him nervous: companies that must lie to stay in business, tiny audit firms, inside boards, glamorous rollups, financial firms, and sunny havens.

Ascertaining the value of a stock requires assessing the four elements of value: profitability or income, life span, growth, and certainty. This is no easy task since these elements “reflect regular patterns of social behavior,” not the laws of physics. “Elevated profitability reflects a product that buyers want that, for whatever reason, they cannot get elsewhere. Longevity is shortened by periods when the immediate demand for a company’s product falls. … Growth reflects either substitution away from a competing product or a product that allows users to do something that they could not do before. Certainty reflects contracts and the general inertia of institutions and human behavior.”

Tillinghast provides case studies to illustrate his points, of which the above are but a tiny sample.

I suspect that most retail investors will be overwhelmed by the amount of work that Tillinghast puts into his investment decisions. They can still learn from his book, even if it’s not to turn their money over to shysters. But for those investors, retail and professional alike, who enjoy research and careful thinking Big Money Thinks Small is an engaging guide.